SERIOUS MONEY:ON THIS day in 1692, John Proctor along with fours others, including the Reverend George Burroughs, were executed by hanging at Gallows Hill in the village of Salem, Massachusetts, having being pronounced guilty of witchcraft and sentenced to death two weeks previously.
More than three centuries later and the “black arts” are clearly being practised on Wall Street. A coven of investment soothsayers has consulted their ouija boards, amid extreme volatility on financial markets, and divined that stock prices have already discounted the dreaded double-dip recession.
The diehard bulls on Wall Street stand accused of misplaced optimism that appears to be based on wishful thinking rather than hard facts. The notion that an economic downturn is already reflected in stock prices at existing levels is simply not supported by the historical evidence.
There have been nine recession-induced declines in the major stock market averages since the mid-1950s. The mean and median drop in stock prices across these bearish episodes was 32 per cent and 28 per cent respectively, as compared with the 18 per cent fall from the recent cyclical high registered in late-April.
Furthermore, stock prices bottomed early last week on valuations – based on cyclically-adjusted earnings – that are several multiple points above the average recorded at the trough of previous recession-induced declines. For current valuations to contract to the typical price/earnings multiple seen at previous cycle lows, the major indices would have to fall by a further 17 to 31 per cent, based on operating and reported numbers respectively.
The verdict of history is clear – the recent decline in stock prices and the resulting valuation multiples do not incorporate an economic downturn. The historical evidence suggests that, given a recession-scenario, the SP 500 could easily drop to 925 and, perhaps even further to below 775, as compared with a recent high of 1,364. In this regard, it is important to stress that the lesser of the two outcomes is more probable, should a downturn materialise, for a number of reasons.
First, a “true” double-dip recession, where the level of real GDP during the up-cycle fails to exceed the previous business peak, has never before occurred in the post-second World War era. The annual revision of the national income and product accounts, published by the Bureau of Economic Analysis last month, revealed that the contraction in economic activity from the winter of 2007 to the summer of 2009 was greater than originally thought – at more than 5 per cent or halfway to a depression – while the subsequent recovery was not as robust as initially reported.
The lacklustre economic momentum since activity bottomed more than two years ago, means that slack in factor markets remains considerable – most notably in the market for labour. The civilian unemployment rate has been north of 8.5 per cent for 31 consecutive months – the longest stretch since the 1930s – and the current reading of 9.3 per cent is four percentage points above the average of the rate recorded at the previous nine business peaks. Not surprisingly, real personal income, excluding transfer payments such as unemployment benefits, is still more than 5 per cent below the cycle peak, which suggests that households are short of firepower.
Second, the growth rate in nominal output, year-on-year and quarter-on-quarter, has rarely been lower when the economy stood on the verge of recession. The pace of current year-on-year growth is roughly half the typical level registered at previous business peaks, while the annual rate of quarter-on-quarter growth is more than two percentage points below its comparable number.
It cannot be stressed enough that a low growth rate in nominal output, combined with debt levels that are close to record highs relative to GDP, means that the economy is vulnerable to a vicious debt-deflation cycle, whereby demand-side constraints lead to falling nominal GDP, soaring unemployment and a catastrophic decline in corporate profits.
The household debt-to-GDP ratio has declined by more than eight percentage points from its peak to below 90 per cent, but the current figure remains high by historical standards, while declining tax revenues relative to GDP, combined with automatic stabilisers and various fiscal stimulus programmes, means that consumers’ deleveraging efforts have been more than offset by the increase in federal and state debt-to-GDP ratios. The bottom line is that the non-financial sector debt-to-GDP ratio has jumped from 226 per cent in 2007 to more than 245 per cent today.
Third, the prolonged “soft patch” in the US economy has already been transmitted to Europe. Eurostat revealed earlier in the week that growth slowed to just 0.2 per cent in the euro zone during the second quarter, as compared with the previous three-month period.
Should a recession in the US materialise, the negative impact on the economic environment in Europe would surface relatively quickly via financial markets, and exacerbate the stress in sovereign debt markets that has already moved beyond the “soft” periphery to Italy and Spain. It is not unreasonable to argue that a full-blown recession in the euro zone, at this juncture, would shut Italy out of the bond market, precipitate more than one sovereign default and a banking crisis that could bring an end to monetary union.
The notion that stock prices have already incorporated a double-dip recession is nothing less than bunkum. The downside risk to stock prices from current levels, should the developed world succumb to recession, is material and cannot be dismissed out of hand, given that governments and central banks lack the firepower to push the economy forward. Tail-risk is high and caution is warranted.
www.charliefell.com
